Author: Ferenc Bánhidi
It is a well-known and widely acknowledged fact that China has continuously been catching up with the developed world for almost forty years. In the last one hundred and fifty years, China’s leading politicians have always wanted more; namely, they wanted “China to take its rightful place in the world”, that is, to rise among the most developed countries. However, the country is several decades away from this goal now. In 2015, China’s gross national product was still 20 to 30 percent less than that of Argentina, Mexico, Brazil or Russia.
THE MIDDLE INCOME TRAP
“The middle income trap” is a well-known notion of modern-day economic history. In the last one hundred and fifty years, there have been several countries that have relatively easily reached a certain degree of economic development, but got stuck there and been unable to approximate the standard of developed countries. According to international statistics, in the 20th century only nine of one-hundred and ten middle-income countries were able to break out of this trap. The above-mentioned Latin-American countries are examples for spectacular failure, and only Japan and the four East Asian Tigers can be mentioned as success stories. China achieved a per capita GDP of $6,000, representing middle income, after 2010; since then, the pace of economic growth has started to slow down spectacularly. How long can the successful catch-up process of the last forty years continue and will be China able to escape the middle income trap, as a small number of countries managed to, and actually reach the standard of developed countries in twenty to thirty years? These are among the most debated questions of Chinese and international experts.
In order to answer these questions, three topics will be explored in more detail:
- Do China’s historic traditions and culture enable China to become one of the most developed countries?
- Have the reforms of the past forty years created a sustainable economy that can drive further growth?
- Can break-out points allowing to avoid the growth trap be identified from the experience of other developing countries?
No ultimate and obvious answers can be promised; hopefully, the analysis of the historical and the recent past will provide some insights that have been ignored by short-term analyses.
THE EFFECTS OF HISTORICAL TRADITIONS ON CHINESE ECONOMY
As for the volume of the historical development of China’s economy, there is more or less a consensus about it now. Economic historian Angus Maddison’s GDP time series encompassing the Middle Ages and the Modern Period are basically accepted by the entire international scene of economic historians. The data obviously reveal that China’s catch-up process of the last forty years can be regarded as a kind if restoration period, since the country boasted the world’s largest population as well as the largest economy in the early 19th century.
As yet, however, the economic and historical sciences have difficulties to provide a meaningful explanation for China’s rise. Either Acemoglu’s1 widely accepted catch-up theory, or, among others, János Kornai’s theory describing the post-Socialist transition are hardly compatible with China’s experiences of the last forty years. Most probably, finding genuine answers takes more time, since the explanation of the rise of East Asian countries, the description of the so-called East Asian development model was provided in 19932, after the process had finished.
Obviously, answers can primarily be expected from Chinese scientists’ researches based on extensive data collection. Fortunately, this field has seen significant development in the last four to five years. From the extensive literature, I have selected the works of economic historian Wu Xiaobo; one of his publications was rated as one of Best Chinese Business Books of the Year3.
According to the prevailing understanding by Western history, the rejection of a free market economy by the traditional Chinese culture and the dominant state ideology blocked economic modernization, resulting in a widening gap between China and the developed world. Analyzing the different eras of three thousand years of Chinese history, Wu Xiaobo demonstrates that the Chinese state was far not as anti-market as that would have followed from the official state ideology. He thinks that certain market economy elements played an important, although not a key, role in traditional Chinese economy:
- Basically, the private ownership of land became predominant before the unification of the country in 221 B.C. Although the institutional system and guarantees of land and money markets were not as developed as in western countries, but existed and were widely used for centuries.
- The most important commodities (salt, iron, silk) practically had a national market and a supporting physical infrastructure (road and canal network) since the unification of the country. In Chinese history, the trade of salt and iron was regulated by state concessions in most periods. They, on the one hand, ensured considerable state income, and, on the other hand, also created the conditions of market-conform trade.
- Education had a history of several hundreds of years and had great importance in the system of social values. Although the content of the curriculum did not meet the requirements of modern economy by the end of the Imperial Period, but was subject to significant development in the early 20th century.
- Certain Chinese products (porcelain, tea, silk) were considered market leaders of international trade even in the 18th and 19th centuries. Prohibitive and restrictive state measures apparently existed but, in part, were applied only in certain periods or just temporarily, or were partly evaded – with the tacit approval of officials.
Acemoglu, as well as other western historians describe the Chinese state as an authoritarian participant, which encroached on the economy, restricted trade, exploited resources, and was a constant source of all-encompassing corruption. Wu Xiaobo absolutely denies this description. The starting point of his analysis is the well-known fact that although Confucianism was the official state ideology, in reality, three different schools blended, representing cultural traditions in a kind of synchronicity. The ideology of Confucianism underestimated economy, and did not believe in a powerful state; Taoism advocated individualism, a kind of pessimism, and therefore believed in non-intervention and deregulation in economy; finally, tradition includes the ideology of an all-prevailing central state, called the school of legislators, but it was highly influential in short periods only.
In the Chinese Middle Ages, under the reign of the Tang and Song Dynasties, between the 7th and 13th centuries, Taoist non-intervention and the self-limiting state concept of Confucianism prevailed. External trade, city markets and the consumption of luxuries thrived. Rich merchant families built their relationships freely with the bureaucracy, market-friendly state regulation gained considerable ground. The period of the Song Dynasty is called the economic revolution of the Middle Ages by Japanese economic historians. In this period, such an economic structure evolved on market principles that was operated partly under the control of the government, but, to a large extent, with its consent. Going back to the long-term economic time series of Maddison, his analyses also confirmed that in these centuries China had been the world’s largest as well as most developed economy.
During the Ming and Qing periods after the Middle Ages, between the 14th and 19th centuries, the concept of state changed; the dictatorial nature of the political system intensified, and the former international openness was replaced by isolation. The emperors of these dynasties tried to keep merchants away from power, and, in addition, prohibited, later restricted foreign commerce for decades. This change of mindset did considerable damage to the economy and the gap between China and the developed countries started to widen gradually. Wu Xiaobo, however, showed that the market-based economy survived under the Qing Dynasty, and, although the state attempted to restrict its scope every now and then, this intention was basically futile.
Although the ideology of Confucianism underestimated the social role of economy, it did not actually seek to exploit or crush the economy. According to the ideal of human, but frugal governance, the size of the Chinese bureaucracy, in terms of the size of the population, was unprecedentedly small, and very little was spent on the military, in compliance with the civil-oriented official ideology; consequently, taxes could be kept low. Apart from Wu Xiaobo, an increasing number of western historians, including members of the California School of economic history, do not describe the operation of the Chinese state in the 19th century as a dictatorship, an exploiter, but quite the reverse: a power with low levels of income and limited resources that was unable to provide public services by the standard of western countries or organize the defence of the country.
To sum up the analysis of the impact of the Chinese historical tradition in the economy, it can be stated that this legacy included such a massive market-oriented behavioural tradition and experience without which the rapid development of the Chinese economy in the last forty years would not have been possible. The economic successes and entrepreneurship of the Southeast Asian communities anticipated decades ago that under adequate political circumstances, the Chinese state would also be able to catch up with developed countries.
EXPERIENCES AND LEARNINGS FROM THE ECONOMIC REFORM PROCESS
These missing political circumstances were created by the reform process launched in 1978. However, economists could not provide a scientific explanation of the fast successes of these reforms, either. Interestingly, this statement applies to both Western and Chinese scientists.
The doyen of Chinese economists, Wu Jinglian, the author of the most known work on the history of Chinese economic reforms translated into English4, has been prevented from it primarily due to the fact that as a distinguished advisor of Chinese governments of the 1980s and 1990’s, he was “too close to the fire” (i.e. power), and could not evaluate events without bias. Professor Wu refrains from overemphasizing Chinese “national characteristics”; he interprets the history of Chinese economic reforms as the history of gradually enforcing the mechanisms of market economy, in which the reformer state and politics have a crucial role. This mindset is very close to the Eastern European market reforms and the recommendations of the World Bank of the time, but is very difficult to be reconciled with historical facts. In the late 1980s, the Chinese government adopted a comprehensive price and tax reform, in line with foreign recommendations, but instead of substantially promoting economic growth, it triggered inflation, acquisition panic, rampant corruption, greatly contributing to the political crisis arising at the end of the 1980s. Professor Wu wrote his renowned book at the beginning of the 2000s, and then he could not know that the new political leadership taking office in 2002 would abandon reforms and strengthen the economic role of the state. This change of direction, however, did not slow down economic growth at all; even the fastest, two-digit GDP increase of the whole reform period was achieved in the period lasting until the outbreak of the world economic crisis.
The other pole of the authors engaged in history of Chinese reforms is represented by Justin Yifu, a Taiwan-born professor at the University of Beijing. He believes in the school of economics supporting an active, developing state, as opposed to market orientation. He thinks, the rationale behind the “Chinese miracle” is the fact that the Chinese government made necessary decisions with adequate content and in a timely manner, and therefore was able to maximally pursue the economy’s comparative advantages of the country. No wonder that this explanation5 has not been widely accepted, either, since it is hard to believe that all the decisions made in the course of forty years by the state, continuously intervening in economic processes, were rational. Professor Lin’s beliefs may effectively be contradicted by simply examining the implementation of the five-year plans produced continuously until today. The actual figures of the last seven five-year plans have been randomly well above, like in the 2000s, or well below targets. The reform period after 1978 saw no significant economic policy packages, from the austerity measures of 1989 and the consolidations of banks in the middle of the 1990s to the economic stimulus package introduced in 2008, included in the current five-year plan.
As opposed to opinions emphasizing the role of the reformer state and the political leadership, the most authentic analysis of the success of Chinese economic reforms was carried out by Nobel-prize winner economist Ronald Coase, who finished his book on the history of reforms just before he died.6 This work, despite the provocative title (How China Became Capitalist), is widely recognized and respected in the People’s Republic of China as well, and the Chinese translation won the 2013 China’s Best Books Award7. Coase’s book includes two extremely important statements that confront the majority of analyses of Chinese reforms. One of the statement is that the outcome of Chinese reforms was not mostly generated by state intervention, but just the opposite, as an effect of the state’s withdrawal from the management of economy, called deregulation. The fact that economic reforms were not adopted according to a programme devised on political level and then implemented top-down is also acknowledged by Chinese politics. Political decision-makers – especially in the 20 years before the turn of the century –, always emphasized that their reform process was characterized by “the method of crossing the river by feeling the stones”, continuous learning and experimenting. Coase and his co-authors argue that what actually happened in the 1980s and 1990s was that central political leadership always gave way to local initiatives that proved to be visibly successful and popular, and approved of their legalization and national-level introduction within a short period of time.
In the 1980s, successful economic reforms were adopted in rural areas. In that period, 70 percent of China’s population lived in villages and towns. The land reform, first started as a spontaneous local initiative and then extended as a pilot, became so popular that it was introduced on national level within three years despite the opposition of conservative political circles. The transformation of land ownership, with a kind of snowball effect, drastically changed also the operation of the industry and services in the countryside. By the end of the 1980s, 30 percent of industrial output was produced by non-state provincial industry and it employed tens of millions of people. Formally, factories were owned by local governments, but their actual operations were dominated by the will of their executives and market orientation. It is not a coincidence that when central leadership started to incentivise export in line with the strategy of opening in foreign policy, it was not urban companies not owned by the state but township and village enterprises that were able to react. These companies were the first to undertake work for hire for Taiwanese and Hong Kong-based partners, thus they had achieved a considerable share also in export by the end of the 1980s.
Urban reforms took place in a similar way in the 1990s. In 1992, upon the invitation of Deng Xiaoping, paramount leader of the time, tens of thousands of state and party officials established privately owned enterprises. Since the growth of GDP in a particular region was the sole criterion of appointing and promoting regional party and state leaders, they did not hinder but support by all means the investments of various private investors. Since the legal status of privately owned enterprises was rather unclear, the majority of newly established companies were operated as joint ventures, involving mainly Taiwanese and Hong Kong-based investors. In the early 1990s, China suddenly took the lead of various rankings regarding the inclusion of international working capital, irrespective of the fact that the embargo measures introduced after the events of 1989 were still in effect and the legal regulation of market operations was in an initial phase.
Ronald Coase’s other statement, drawn from the analysis of reform process, was that the private sector played a key role in economic growth and the expansion of employment in most of the reform period.
Western analysts prefer to call the current Chinese economic regime state capitalism, referring to the fact that the state plays a decisive role both in the governance of economy and ownership. Another frequently voiced statement is that state-owned companies enjoy such privileges in the distribution of resources, including access to loans, or regarding market entry that prevents private enterprises from competing with them.
As for ownership, the fact that Chinese political leaders consciously avoided using the expression “privatization” for ideological reasons was misleading for external observers for a long time. In fact, a rapid and comprehensive campaign was organised in the late 1990s, concerning thousands of mainly small and medium-sized enterprises owned by the state or local governments; but it was not called privatisation but restructuring. The scale of the restructuring is reflected by the fact that some 40 million employees of state-owned companies lost their jobs in this period of three or four years, according to various sources. The main beneficiaries of this campaign were domestic investors, primarily the managers of the existing companies. As it has already been mentioned, the majority of the companies owned by local governments were practically operated as privately owned companies from the middle of the 1980s; they were finally legalized by this campaign, and companies that were owned by cities and whose former management became owners joined them. The significance of this reform campaign is indicated by the fact that today’s internationally market-leader Chinese companies, such as Haier, the market leader of the household appliances market, and Lenovo, the leader of the PC market, became privately owned in this period. A populous stratum of entrepreneurs also evolved at that time, and they could influence the economic decisions of the government as well in the past 15 years.
As for the second statement, namely that private enterprises are in continuous market disadvantage in comparison with state-owned ones, it was most effectively denied by the famous American Sinologist, Nicholas Lardy. On the basis of official Chinese statistics8, he showed that the market share of state-owned companies in industrial output had decreased from 80 percent in 1978 to below 25 percent by 2013. Companies owned by the state and local governments had 100 percent share on urban employment in 1978, but this figure dropped to 18% by 2013. Rural employment was also completely transferred into the private sector. Although the number of people engaged in direct agricultural activities decreased by 60 million, almost all of them were snatched up by the private industry of villages and townships and the non-agricultural activities of households. These statistics apparently prove that, on the whole, the vigour and dynamism of the private sector was a decisive drive of the development of Chinese economy, even though some hurdles hindered the operations of private enterprises in some industries.
Contribution to average annual GDP growth, broken down into factors, 1978-2000
|Contribution to average annual real GDP growth, in %, 1978-2000||Four Asian Tigers
(Korea, Taiwan, Singapore, Hong Kong)
Source: Jonathan Anderson How to think on China 2006 UBS Investment Research
From the analysis of the Chinese reform process, we can draw the conclusion that such an economic system has evolved by today that is predominated by market mechanisms and private ownership. This system has evolved gradually, step by step; in this process, the state did not adopt a pre-planned programme, but, under control, gave room to entrepreneurship and commercial traditions, which are deeply rooted in Chinese culture.
ESCAPING THE MIDDLE INCOME TRAP
The economic background of the middle income trap can be easily described. A catching up country can develop relatively rapidly for a long time by applying technologies that are not international cutting edges but still marketable and used in developed countries for years. By doing so, the country saves R&D costs, while technologies that are on their way out can be obtained from cutting-edge countries relatively cheaply and easily. It can, however, focus the use of marketable technologies on such labour-intensive activities such as assembling products, in which it can use its main competitive advantage for wages that are significantly lower than those of developed countries. The farther a developing country is from the level of developed countries, the more easily and cheaply available these opportunities are. As they approximate the technological level of developed countries, the cost of acquiring new technologies increase; as the differences between the consumption levels of a developed and a developing country is decreasing, the competitive advantage in employment is also gradually diminishing. As it has been mentioned in the introduction, China reached such an income level two or three years ago that made it face the above phenomenon, the loss of advantage due to high wages, and the difficulties of acquiring state-of-the-art technologies. The middle income trap is not the result of a mistake of the economic policy or of an institutional defect, but a phenomenon occurring as a rule, with which each catching-up country has to tackle. Successful countries, such as Japan or the Four Asian Tigers can also serve as role models to find ways to escape. The experiences of these countries greatly converge: the main tool to escape the trap is to develop domestic innovation, which is much more than increasing the state subsidy of R&D. A new growth model must be adopted, in which innovation is placed in the focus of companies’ operations and the main goal is to increase innovation productivity.
It is not an easy task to measure innovation productivity. The index most frequently used in the analyses of international economic organisations, including OECD and the World Bank, is the so-called factor productivity. Factor productivity accounts for effects in total GDP growth relative to the growth in traditionally measured inputs of production factors (labour and capital); the theory of macroeconomics regards this element the effect of innovation. The definition based on the residual principle simplifies the calculation of the index, because all growth effect not attributable to the growth of these two basic factors of production, i.e. capital and labour, are regarded as the effect of innovation. It is known that in the initial phase of economic reforms, China adopted the model of the Four Asian Tigers in its growth strategy. In most of this period, even the tigers were far from the forefront of technological growth, therefore they adopted the traditional, investment-oriented model.
The above table demonstrates the main characteristics of this growth trajectory: the major driver of economic growth is not innovation but the contribution of the capital factor, i.e. investments. Thanks to the high and continuously increasing share of savings and the rate of accumulated savings these countries could achieve an above-average growth of 7-8 percent despite their relatively low factor productivity. This period, however, ended when the “middle income” was reached by the tigers in the 1990s and by China after 2010.
Total factor productivity growth in China, 1995-2012
Source: OECD Economic Surveys China 2015
If a country reaches the middle income level, the efficiency of investments deteriorates as they approximate the forefront of technology. The rate of accumulated savings cannot be further increased because it would limit the growth of consumption and the expansion of internal market. On top of that, in China the reserves of workforce are running out, owing to a population policy that encouraged a fall in birth rates and was in effect for a long time.
In the last three or four years, Chinese political decision-makers have faced the fact that increasing factor productivity, that is, developing innovation, may be considered the only driver of economic growth in the next period, because without this the pace of China’s growth would practically drop to the level of developed countries, resulting in losing the hope to catch up as planned.
In western literature, we can often read statements that China is doomed to fall behind in the international R&D competition primarily due to its political regime, its regulations restricting freedom of speech and expression, and will not be capable of innovation, imperative to achieve permanent economic growth, in the long term. International statistics and analyses, however, show that the productivity of Chinese processes of innovation has not fallen or is falling short of the results achieved on similar level of development by other countries. From this point of view, the data included in the country report issued by OECD in 2015 are especially convincing.
In the period between 1995 and 2012, total factor productivity contributed to the GDP growth annually by 5 percent on average. The previous decade was particularly successful: between 1999 and 2007, the contribution of total factor productivity to GDP growth tripled, from 2 percent to 6 percent.
To sum it up, it has a key role in assessing China’s long-term growth perspective how the future development opportunities of innovation are evaluated. Past experiences suggest that the development of innovation is not hindered by any institutional or structural hurdles in China.
Author: Ferenc Bánhidi